If you've had a heart-to-heart with your grandparents, chances are, you would have heard them tell you how a bar of chocolate cost them ten paise in their heydays. About 50 years ago, it would have been possible to cap an entire month's spending at Rs. 100. Today, you get chocolate bars for that rate.

What does that tell you about the value of money? It changes over time. To put it more specifically, the value of money declines over time because of something called inflation.

What is inflation?

Inflation is the rate at which the price of goods and services in an economy rises over time. As the price of various things shoots up, each unit of money can buy you fewer things. In other words, inflation erodes the purchasing power of money. Your household and business expenses rise with inflation while your ability to save for the future declines.

To understand inflation better, you need to remember that money's value is relative. Money's worth is attached to what and how much of something you can exchange it for. Inflation pushes up the price of things in the market, making your money less valuable.

Let's look at an example to understand this better. Say you are a clothing manufacturer. Two years ago, you could buy one metre of cotton cloth at Rs. 50. After inflation, the price of the cloth rises to Rs. 60 per metre. Your cost of production of clothes will consequently go up. You could pass on this increase to your customers via a rate hike or absorb the loss yourself. If you pass on the hike to your customers, there's a chance that some of your customers may not be able to afford it. This will impact your sales and, consequently, your bottom line. If you absorb the cost, you will still be incurring higher rates and lower profit. In general, inflation makes everything expensive and strains your budget.

Understanding inflation

When it comes to inflation, there are two kinds you should know about:

• Hyperinflation

Hyperinflation occurs when the price of goods and services in the country increases rapidly, and the country's currency value reduces. You need to see an inflation of at least 50% to call it hyperinflation. This type of inflation is very rare, but it has occurred in the past during civil unrest, war, or when regimes have been overthrown, effectively rendering currency worthless.

• Stagflation

Stagflation happens when inflation remains high while the economy stagnates and unemployment increases. When unemployment rises, consumer demand usually falls as people cut back on spending. As demand falls, prices also fall, thus helping to rebalance purchasing power. Stagflation, on the other hand, occurs when prices remain high even while consumer spending falls, making it more expensive to buy the same commodities.

Inflation occurs in two ways – demand-pull inflation and cost-push inflation. Demand-pull inflation occurs when the demand for goods or services rises but supply remains unchanged, causing prices to rise. Cost-push inflation occurs when the supply of goods or services is restricted, but demand stays constant, thus pushing prices higher.

Inflation affects essentials more than non-essential goods. For instance, you would buy rice even if its price went up by 5% because it is necessary. However, you would probably hold back on purchasing perfume if its price went up.

Inflation is measured using the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). The CPI calculates the difference in the price of commodities and services such as food, medical care, education, electronics, etc. The WPI measures wholesale and retail-level price changes.

Understanding how inflation works is crucial because it directly impacts your cash flow, affordability and saving ability. When inflation rises, you may have to take a relook at your financial budget to ensure that you stay the course on your personal and financial goals.

Impact of inflation

Inflation directly impacts the money supply, interest rates in the economy and debt. When inflation rises, the money supply in the economy also rises. The government will print more money to keep up with inflation. Prices will rise in tandem, therefore not increasing the value of money in essence. Thus, inflation and money supply are positively correlated.

Inflation also has an impact on debt. When inflation rises, the government increases interest rates to control inflation. When interest rates go up, the cost of borrowing increases.

However, the impact of rising interest rates can play out in two ways – if you have already borrowed money at a fixed rate, the effective interest you pay goes down. While borrowing new funds, the cost of borrowing goes up. Whether inflation impacts the borrower or the lender depends on when you are borrowing.

Takeaway

Inflation is a global concern at present. Central banks worldwide are increasing interest rates, one of the most relied-upon tools to manage inflation. As a result, borrowing is becoming costlier. To stay ahead of inflation, you must invest your money wisely in avenues that provide inflation-beating returns. If you have doubts about managing your financial portfolio, speak to a financial advisor for guidance.